The vote for Brexit will change the course of Britain’s history, Philip Hammond announced last month. The UK chancellor may be a strident advocate for a soft departure from the EU but he has also been keen to paint a positive picture of the country’s economy, saying the UK’s fundamental strengths will “ensure our future success”.
Financial markets are sceptical. The economy may have confounded doom laden predictions of recession and market seizures in the immediate aftermath of the June vote, but any sense of relief is yielding to bleak predictions for 2017.
The pound remains 17 per cent lower against the US dollar than it was before the referendum — weakness that Charles Goodhart, a former Bank of England policymaker and professor of finance at the London School of Economics, says illustrates the way in which investors have marked down the UK’s economy.
They are positioned for further weakness in the pound, with the currency viewed as being vulnerable to another sharp decline when Theresa May, prime minister, finally sends the EU the Article 50 letter that formally activates divorce proceedings.
At the same time, British government bonds have become ensnared in a global debt market retreat with sliding prices pushing up yields. As inflation expectations rise across developed world markets, the UK story is compounded by sterling’s large drop.
Not surprisingly, holders of gilts have suffered the biggest total return losses in developed world bond markets between the end of August and beginning of December.
Even UK equities are reflecting the sombre mood and not benefiting from money managers rotating money from bonds into shares.
The pound’s fall may have helped large companies that generate most of their earnings overseas, but members of the blue-chip FTSE 100 and smaller FTSE 250 have failed to keep pace with the rally in US markets that pushed all major Wall Street indices to record highs in December, and also boosted European stocks.
“The US is leading a reflation trade in which investors switch from bonds to equities in the expectation of greater growth and inflation. The UK isn’t telling the same story,” says David Riley, senior portfolio manager at BlueBay Asset Management. “We’re looking at a situation in which economic growth is stagnant yet inflation is rising. This is a terrible combination for investors in which neither equities nor fixed income perform well.”
Even if EU negotiations limit political “fallout” next year, the International Monetary Fund predicts UK growth will be just 1.1 per cent in 2017 — half the previous forecast. Meanwhile, inflation is expected to outstrip the Bank of England’s 2 per cent target.
Adding to the anxiety around the UK outlook, the central bank support that acted as a ballast to asset prices in the wake of the vote for Brexit is losing its shine.
On the morning of the EU referendum result, with financial markets in tumult, the political architects of Brexit absent and prime minister David Cameron having announced his resignation, BoE governor Mark Carney appeared on television and told the public (and markets) that everything was under control.
“The market response was textbook,” says Iain Stealey, fixed-income portfolio manager at JPMorgan Asset Management.
“Things eased as people realised that the Brexit process would take time and the economy had not immediately fallen off a cliff. Once the BoE and ECB [European Central Bank] were making soothing noises people began buying again.”
That support is now less forthcoming. The BoE is not currently expected to ease further, and the ECB has announced its bond-buying programme will be extended via smaller monthly purchases next year.
With the cushioning effect of central bank support deflating, markets are left with the unenviable challenge of speculating on how Brexit negotiations will proceed.
A hard Brexit that does not give companies time to adapt is considered the worst-case scenario — one that would create economic and financial disruption, warns Wouter Sturkenboom, investment strategist at Russell Investments.
There is, however, an alternative scenario. If anti-elite sentiment dominates next year’s elections in the Netherlands, France and Germany (an election in Italy is also possible), the EU may be obliged to adopt what Steen Jakobsen, chief economist at Saxo Bank, calls “a more co-operative stance towards the UK”.
Economic data may also remain better than expected and any signs a Brexit transitional deal is possible would soothe short-term concern. Donald Trump’s arrival at the White House could herald a bilateral US-UK trade deal, as well as increasing what strategists at Bank of America Merrill Lynch call “the geopolitical importance of the UK for the rest of the EU”. Sterling tail risks are “skewed to the upside” and the bank’s analysts recommend selling the euro against sterling.
Then there’s the outlier scenario. In its annual outrageous predictions for the new year, Saxo Bank includes the possibility that “Brexit never happens”.
Far fetched? Recommending a trade of buying sterling against the yen, Jordan Rochester, currency strategist at Japanese bank Nomura, says: “With politics, one cannot rule anything out”. 2016 was the year politics “stumped the consensus”. Why not 2017?